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Cash flow modelling – the issues with assumptions

6 May 2019

The assumptions advice firms make when using cashflow models, particularly in planning DB transfers, are widely variable, warns ATEB Consulting’s Steve Bailey

When reviewing advice on DB transfers, it is not uncommon for us to come across cases where different projections result in the client receiving a mixed message. For example:

 

Factor                                                            Indicating

Critical yield (or TVC) is very high               Transfer is unlikely to be advisable

Drawdown run out age is high                    … but your fund will never run out

Cash flow model is ‘optimistic’                   … and your income will be higher too!

The first two factors appear in the Pension Transfer Report (previously the TVAS), so it is understandable that advisers might assume that these are comparable – but they are not. They measure entirely different things and are based on entirely different assumptions. These differences need to be understood and explained to clients.

Cash flow models are increasingly being used by firms when advising on pension transfers, and the assumptions that firms make are widely variable, in particular, the growth rate. This often results in cash flow models that give an impression of the client’s future financial situation that is not only more optimistic than realistic, but also confusingly different to the indications from the key elements of the Pension Transfer Report, namely the TVC and critical yield figures.

The FCA considered the use of cash flow models when finalising the new transfer advice rules that took effect in 2018 and decided against requiring their use. In fact, the FCA has concerns about the use of cash flow models –of which more later.

However, the rules do not preclude the use of cash flow models, or other projections, provided certain conditions are met. Identifying those conditions is not easy as they are contained in several different places within the FCA Handbook. The key requirements are:

  • such analyses must not be given more prominence than an analysis prepared in accordance with COBS 19 Annex 4A;
  • projected outcomes at the 50th percentile must be no less conservative than if the analysis had been prepared in accordance with COBS 19 Annex 4A and COBS 19 Annex 4C;
  • any indication of future performance must comply with COBS 4.6.7R, the key points of which include:
    – it is not based on and does not refer to simulated past performance;
    – it is based on reasonable assumptions supported by objective data;
    – the effect of commissions, fees or other charges is disclosed;
    – it contains a prominent warning that such forecasts are not a
    reliable indicator of future performance.
  • the projection must use rates of return which reflect the investment potential of the assets in which the retail client’s funds would be invested under the proposed arrangement;
  • use more cautious assumptions where appropriate;
  • when making assumptions about the rate of return under COBS 19 Annex 4A, a firm should consider consistency with other assumptions (such as inflation and exchange rates);
  • assumptions must take account of all charges that may be incurred by the retail client as a result of a pension transfer or pension conversion and subsequent access to funds following such a transaction (except for non-contingent charges or charges paid by a third party e.g. the employer;
  • charges that should be included in the analysis include:
    – product and fund charges;
    – platform charges;
    – adviser charges in relation to the personal recommendation and
    subsequently during the pre-retirement period as well as at benefit
    crystallisation and beyond, where likely to be relevant;
    – and any other charges that may be incurred if amounts are
    subsequently withdrawn;
  • different assumptions that produce different illustrative financial outcomes should be clearly explained to the client.

Meeting the requirements (continued over page)

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